What the Fall of the Pound Means for the UK’s Economy?

By Kerrm Ahsan

On Monday, September 26, the UK woke up to shocking news that the Pound Sterling had fallen to a record new low against the US Dollar. The pound fell to $1.03 dollars, after coasting on an average exchange rate of $1.26 for most of 2022. In the past few months the UK’s economy has shifted drastically; what was expected to be a strong post-pandemic recovery evolved into a rapid decline as hurdle after hurdle was thrown at the nation. The pound’s decline is just one of several new economic challenges the UK must face as the taste of recession looms in the air.

The continuing development in the pound’s decline can partially be attributed to newly-elected Prime Minister Liz Truss’s declaration of tax cuts. Truss’s tax cuts intend to increase government borrowing to pay for a tax break. Truss’s administration claims that the initiation of these tax cuts will generate more economic activity through more investment, and in the long term create higher tax revenues, as the rest of the UK prepares for a tough winter. The tax cuts and spending package introduced by Truss’s ruling Conservative Party mirrors that of leaders prior who also turned to “trickle – down” economics in times of trouble.

During the 1980’s, leaders like Ronald Reagan and Margaret Thatcher began experimenting with economic policies that favored those in higher income tax brackets. They embraced the idea that lower taxes would increase the disposable income of agents in the economy, which therefore would urge them to spend more (through consumption and investment) and in turn get the economy up and running. During the 1980’s, Reagan’s practice of “Reaganomics” reduced tax rates from 70% to 28% for households that were making over $108,000. Similarly Truss’s plan intends to reduce tax rates from 45 % to 40 % for earners in the UK making upwards of £150,000. One of the primary downsides of Reaganomics was the immense increase in government spending that contributed to the national debt. Under Reagan, the United States national debt tripled, from under $1 billion in 1981 to nearly $2.6 billion in 1988. The same concern also applies to the UK’s national debt. Truss’s policy will force the government to borrow heavily to pay for the tax cuts. It is estimated that her plan will cause government borrowing to hit £100 billion within a year.

Critics of Truss’s plan point out that the increase in national debt is not the only flaw in her agenda. Many investors claim that the high budget deficit will lead to an increase in inflation in the UK, which has already been on a rapid rise since the start of the year. This past summer, inflation reached a 40-year high, nearing 10.1 %, contributing heavily to the UK’s ongoing cost of living crisis in which the price of essential goods rose rapidly in comparison to the income of the average household. The top sectors affected by this growing inflation were food and energy groups. The rise in these prices is due to a number of factors, primarily supply chain issues as well as the ongoing crisis in Ukraine. These factors have severely impacted the UK’s Consumer Price Index. The UK’s CPI stood at 9.9% in the 12 months to August – nearly five times the Government’s 2% target. It is expected to rise past 13% by January 2023.

             Truss’s new tax plan and the fall of the pound is just another one of the most recent developments in the evolving decline of the UK’s economy, but what about the economies of other nations? The US dollar for instance has reached a 20 year high and its strength has risen by 15% in comparison to other currencies such as the Yen, Won, Euro and Pound. But how does the UK’s declining economic state affect the US’s growth? Fortunately for the US, the economic fate of the UK has stayed within the UK. The American economy seems to only be thriving off the struggles across the pond. Since the strengthening of the dollar has gone up, countries with weaker currencies are selling their goods and services to the US for cheaper and are seeing a boost in exports. The dollar, however, has always had a huge influence in the international market given its status as a reserve currency. A reserve currency is a large amount of currency that is held by major banks and is primarily used for international transactions. Essentially the dollar is a currency that reduces exchange rate risk since there’s no need for excessive currency exchanges from one country to another to conduct trade. Many commodities are priced in USD and that further encourages countries to hold onto the dollar to pay for these goods. The pound on the other hand is not a reserve currency so its status through an international lens is very inconsistent. Governments and investors in foreign countries are now borrowing money in US dollars rather than their own currencies because of the dollar’s stability. On the contrary, the pound’s decline has severely impacted its appeal to investors. Foreign investors will be taking in less profit after the pound is converted into their local currency and, as a result, are pulling out their investments.

However, the pound’s fall is not all gloom and doom for the UK. There is a bit of a silver lining that can be found for UK nationals following the currency’s decline. One benefit is the increased demand for domestic products. With the weak pound making UK exports relatively cheap to foreign countries, the UK’s exports have now gained a bargain status. This will lead to improvements in Britain’s economic growth but will also benefit smaller contributors within the UK such as farmers and manufacturers.

With a return of tax policies akin to the age-old ‘trickle-down’ economics of Reagan and Thatcher, inflation being at an all-time high, and the largest fall in the Pound’s value in decades, the state of the UK’s economy remains up in the air. While there are attempts to reshape the economy it is unknown whether these changes are for better or worse. Markets have scrambled in the aftermath of the fall of the Pound, however, its effect on net exports means that it may not be as large of a disaster as originally thought. Liz Truss’s forthcoming economic policies are going to reshape the UK one way or another. Whether that be an unparalleled success or a colossal failure, it is all just a waiting game

The views expressed in this article are the author’s own, and may not reflect the opinions of  The St Andrews Economist.

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